Confounded Interest: Why Housing Continues to Perplex Lenders

Craig Blunden started Provident Financial Holdings' mortgage shop in 1987, and has witnessed a lot of cycles. The "craziest" time, not surprisingly, came in the mid-00s. Real estate in California's Inland Empire was white hot, and lenders willingly tossed fuel on the fire.

"Stated-income loans were big here; option ARMs were big. You had four hairdressers pooling their money to buy a house and flip it," recalls Blunden, now Riverside, Calif.-based Provident's CEO. "We had to participate in those things to compete. If we didn't do it, we would have needed to lock up our doors."

Today, things are much calmer — too calm for Blunden's taste really. After two years of healthy home price increases and activity, the market is stalling. Inventories of for-sale properties have shrunk and affordability — the median price of a house in southern California is around $300,000 — has become an issue.

In its fiscal fourth quarter, ended in June, Provident's originations of single-family mortgages fell to $477 million, down 43% from the year-earlier period. With the home lending business under pressure, Blunden recently redeployed manpower from mortgage originations to commercial real estate, a sector that he says looks promising, but is still weak. "It's been really slow coming out of this recession," Blunden says.

The herky-jerky revival of the housing market is causing headaches and strategic concerns for banks everywhere. Though the residential real estate market is starting to recover in some places, it remains dormant in others and, perhaps most unsettling for bankers, is prone to yo-yo in areas like southern California and Las Vegas, where big jumps in prices and sales volumes have been followed by lulls.

Average prices are up nationally — 9.3% for the year ended in June, according to the S&P/Case-Shiller Index. The National Association of Realtors reports that sales of existing homes jumped 2.6% in June, the third consecutive month of increases. But new home sales, considered vital to the broader economy, fell 4.9% nationally during the first half of the year, according to the Census Bureau.

The Mortgage Bankers Association predicts that total originations will come in right around $1 trillion for the year, which would be the lowest level in two decades and a steep drop from last year's $1.7 trillion.

"The real disappointment this year has been a weaker purchase market than expected," says Mike Fratantoni, the MBA's chief economist. "We're looking at about a 10% decline in purchase volume relative to 2013."

The housing market's struggles are an issue for revenue-starved banks. According to Keefe Bruyette & Woods, more than 30 percent of industry balance sheets — roughly $3.5 trillion — are directly related to the buying and selling of homes. Throw in loans to ancillary commercial business, such as contractors and retailers, and the figure climbs higher.

"The strength of the housing market is a pretty good indicator for what makes banks profitable," says KBW analyst Fred Cannon. In a healthy market, "collateral values are going up, people feel confident and borrow more, and credit quality is usually pretty good."

KBW notes that the stocks of banks in California and Nevada, where home prices have shown stronger appreciation, have higher median valuations than those in the Midwest or Northeast, where house prices have been more stagnant. "When housing suffers, banks usually don't do as well," Cannon says.

At Wells Fargo, the nation's largest housing lender, second-quarter revenues declined to $21.1 billion from $21.4 billion a year earlier; over the same period, revenues from mortgage originations and sales plunged 71%, to $688 million from $2.4 billion. Earnings rose 3%.

"If you exclude mortgage, they're humming on all cylinders," says Scott Siefers, an analyst with Sandler O'Neill & Partners. "There's no question about it. If you had a normal housing market, they'd be flying high."

The story is much the same elsewhere. In the first quarter — admittedly a rough one due to particularly heavy snowfall in the Northeast and Midwest — the industry's mortgage banking fees were down from the year-earlier period by a whopping 53.6%, to $4 billion, according to the Federal Deposit Insurance Corp. Originations, at $235 billion, were the lowest in recent memory.

The second quarter saw originations jump to an estimated $267 billion, according to the MBA, and many banks reported higher mortgage-related revenues. But it's all a pittance relative to recent years, and profits remain under pressure — especially when the escalating cost of regulation is added to the equation.

The typical lender has been losing money on every new loan, due to rate competition, mandated caps on origination fees and, of course, higher compliance costs, says the MBA's Fratantoni. "Even when the revenues are doing fine, the expenses are going through the roof."

The housing market has obviously caused the banking industry a lot of pain. Beyond the hundreds of billions in losses and mountains of regulatory fallout, bank reputations took a huge hit from which they have yet to recover. It seems barely a week goes by without one bank or another reaching a big-money settlement with the Justice Department or some agency related to the subprime crisis.

The frustration among bankers is palpable; there's a sense that housing owes the industry after six years of saga. As Ed Wehmer, CEO of the $19 billion-asset Wintrust Financial in Chicago, says: "Housing got us into this mess. Housing has to get us out of it."

Yet finding a catalyst remains elusive. While many other lending segments, including auto and commercial, are showing impressive gains, the jumpstart that the housing market — and the broader economy — needs has yet to emerge.

"Everyone believed that the recovery would be spurred by housing," says Liz Jordan, a director who specializes in credit and lending for Deloitte & Touche LLP. "Now that things have slowed, we're seeing concern about the implications for a full recovery."

Originations were thrown a lifeline by the Federal Reserve's Quantitative Easing program, which in recent years fueled an unprecedented refinancing boom that kept lenders busy. In 2013, refis accounted for $1.1 trillion, or 66% of all originations, according to the MBA.

Oh, the poor banks. Having ensured that regulation would primarily impact brokers, they had a near monopoly. That allows them to charge 1/2to1% higher in rate than the few remaining brokers. Now even with that huge margin they cannot make money????